Here's Why China Shenhua Energy (HKG:1088) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies China Shenhua Energy Company Limited (HKG:1088) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Shenhua Energy

What Is China Shenhua Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that China Shenhua Energy had CN¥34.0b of debt in March 2024, down from CN¥52.7b, one year before. However, it does have CN¥158.1b in cash offsetting this, leading to net cash of CN¥124.1b.

How Healthy Is China Shenhua Energy's Balance Sheet?

The latest balance sheet data shows that China Shenhua Energy had liabilities of CN¥93.0b due within a year, and liabilities of CN¥61.0b falling due after that. Offsetting these obligations, it had cash of CN¥158.1b as well as receivables valued at CN¥20.3b due within 12 months. So it actually has CN¥24.4b more liquid assets than total liabilities.

This short term liquidity is a sign that China Shenhua Energy could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, China Shenhua Energy boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, China Shenhua Energy's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Shenhua Energy's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China Shenhua Energy has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, China Shenhua Energy recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that China Shenhua Energy has net cash of CN¥124.1b, as well as more liquid assets than liabilities. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in CN¥52b. So we don't think China Shenhua Energy's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for China Shenhua Energy that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com